How Do Puts & Calls Work in the Stock Market?
Puts and calls are the two sides of stock options. A stock option is the right to buy or sell a stock at a certain price for a limited period of time. The holder of a call option has the right to purchase shares of the underlying stock at a certain price until the expiration date of the option. The holder of a put option has the right to sell the stock at the option price before the expiration date. A single option contract is the right to buy or sell 100 shares of the underlying stock. If you buy or hold options contracts, you are said to be "long" the puts or calls. A seller of option contracts is "short" the puts or calls.
Other People Are Reading
-
Prices and Dates
-
The price at which an option can be exercised is called the "strike price." For call options, if the underlying stock price is above the strike price, the option is said to be "in-the-money" or ITM. If the stock price is below the strike price, the option is "out-of-the-money" or OTM. "At-the-money," ATM, occurs when the stock price equals the strike price of the option. Put options are ITM when the stock price is below the option strike price and OTM when above the strike price. The expiration date for options is the Saturday following the third Friday of the month. Regular options have expirations from one to nine months.
Using Options
-
An investor or trader can use options to make a short-term profit on the price movement of the underlying stocks. If he thinks the stock price will go up, he can buy or go long a call option on the stock. If he thinks the stock price will fall, buying or being long a put option will profit if the stock falls below the strike price. Options provide leverage on the underlying stock price, increasing the profit percentage if the stock moves in the correct direction.
For example, on July 28, 2009, IBM stock is selling for $116 per share. The September $120 call option has a price of $2.40. It would cost an investor $11,600 plus commission to buy 100 shares of IBM, but only $240 plus commission for one call option contract. If IBM stock increases to $125 per share before expiration, the 100 shares would gain $900 or 7.7 percent. The call option would be worth at least $500, or a 108 percent gain. Put options work in the opposite direction with the option holder gaining in profit as the stock price falls below the strike price.
To sell or be short options is a strategy to collect the option premium from the option buyer, then profit when the stock price reaches expiration OTM. The seller of the IBM September $120 call option will keep the $240 if the option expires OTM. If the stock reaches expiration ITM, he will have to sell the stock at $120 per share to the call option holder. Sellers of put options must buy the stock at the strike price if the stock is ITM at expiration.
-
Expiration
-
At expiration, the holder of an ITM call option must purchase 100 shares of the underlying stock at the strike price. If she does not want to own the stock, the option should be sold before expiration. The holder of an ITM put option must have 100 shares of the stock to sell. Option holders can elect to exercise the option at anytime prior to expiration.
-
